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Although Congress has recently renewed the Internet Tax Freedom Act ("ITFA" or the "Act"),1 its renewal primarily serves to highlight popular misconceptions about its scope and the fundamental issues it does not address. The most significant of these issues is whether state and local jurisdictions ("taxing jurisdictions") may impose sales and use tax collection obligations on non-domiciliary Internet-based vendors ("remote vendors"). This issue is resolved by determining whether a remote vendor has a sufficient physical presence in a jurisdiction ("nexus") to constitutionally justify the imposition of tax collection responsibilities for sales made to local customers. This determination is substantially complicated because of the fundamental nature of electronic commerce ("e-commerce"), particularly the growing prevalence of "bricks-and-clicks" relationships between online and offline businesses.
The issues of nexus and tax collection obligations have never been so important because incremental growth of a remote vendor can often expose it to substantial new tax liabilities and
compliance obligations just at a time when the states, under new fiscal pressures, are becoming more aggressive in trying to tax e-commerce. Failure to correctly identify the point at
which tax collection obligations arise in the nation's approximately 7,500 taxing jurisdictions2 also potentially subjects a remote vendor itself to payment of all past uncollected taxes on sales. The effect on even a robust remote vendor could be devastating.
This article will first outline the federal constitutional and statutory limitations on a taxing jurisdiction that seeks to establish nexus with a remote vendor. This will assist counsel
in advising Utah-based clients on "out-bound" e-commerce transactions - that is, where a local vendor seeks to sell its goods in out-of-state markets. Finally, the article will
offer several items of practical advice to legal counsel and remote vendors.
Sales and Use Taxes: A Primer
States generally impose a sales tax on the retail sale of tangible personal property and certain services in the state. Most states impose a sales
tax on the vendor, though the vendor customarily collects the tax from its customers at the time of the sale.3 To make their taxing schemes comprehensive, most states also impose a complementary "use tax" that purports to reach out-of-state sales of property to a state's residents for use, storage or consumption in the state. Through use taxes, states seek to prevent the erosion of their individual tax bases when their residents make purchases in other states. Use taxes may be imposed on individual taxpayers as well as vendors but taxing jurisdictions generally rely on individual self-assessment for collection of the tax. But as it is practically impossible for a state to audit all of its residents for use tax purposes, they must instead rely on remote vendors to collect and remit the tax, or it will generally go unpaid.
This highlights the necessity for taxing jurisdictions to establish nexus with remote vendors, particularly in the context of e-commerce. Without establishing nexus with remote vendors, an
estimated $26 billion in sales and use taxes will go uncollected by taxing jurisdictions.4
The Internet Tax Freedom Act
The Act is popularly misconceived as having suspended nexus rules regarding purchases made over the Internet, thereby freeing Internet sales from
sales and use tax. However, the Act is substantially narrower in scope and only reaches certain Internet-related activities. The Act provides that taxing jurisdictions may neither impose
(1) taxes on Internet access unless such taxes were generally imposed and actually collected prior to October 1, 1998,5 nor (2) multiple or discriminatory taxes on electronic commerce.6 The moratorium's application to Internet access means that, unless the taxing jurisdictions imposed taxes on Internet access charges before October 1, 1998, a taxing jurisdiction may not tax any fees paid to an Internet Service Provider ("ISP"), such as America Online, the Microsoft Network, or Earthlink. The Act's definition of Internet access service does not include telecommunications services.7 Therefore, the moratorium's application does not likely extend to a jurisdiction's taxation of fees paid to service providers that provide high speed (for example, digital subscriber line) or other access to an ISP, as these services are generally characterized as telecommunications services that occur in intrastate rather than in interstate commerce.
The Act's prohibition of multiple or discriminatory taxation is the portion that affects remote sellers. This prohibition prevents a taxing jurisdiction from imposing a duty to collect
sales or use taxes on: (1) a remote seller that does not have nexus with the jurisdiction where the purchaser resides; or (2) an ISP as an agent providing the remote vendor a means to
conduct sales.8 Popular misconceptions aside, the Act does not modify the duty of a remote vendor with nexus in a state from collecting sales and use tax on sales made to customers in the state. Nexus is not defined in the Act9 and resort must be made to general case law.
"Nexus" As a Constitutional Principle
The Dormant Commerce Clause10 is the principal11 restraint on a taxing jurisdiction's efforts to establish nexus with a remote vendor. In the seminal case of Quill Corp. v. North Dakota,12 the U.S. Supreme Court reaffirmed the long-standing rule that a taxing jurisdiction may establish nexus with a remote vendor only if the vendor is physically present in the jurisdiction. Though it seemingly established a formal rule, Quill largely leaves open the crucial inquiry of what level of physical presence is required for a jurisdiction to establish nexus.
In Quill, the remote vendor was a Delaware corporation that sold approximately $1 million worth of office supplies through direct-mail advertising to approximately 3,000 customers
in North Dakota. Except for the presence of software that it licensed to its customers, the taxpayer did not have any property in the state. All of its products were delivered in North
Dakota by common carriers. The Court held that delivery of goods through a common carrier alone did not constitute a physical presence.
In a case that pre-dates Quill, National Geographic Society v. California Board of Equalization,13 the Court held that a remote vendor's "continuous presence" in the state, in the form of two offices, was sufficient to establish nexus. Still, the Court rejected the lower court's ruling that the "slightest presence" in state was sufficient to establish nexus.
Within this spectrum from Quill - requiring a physical presence - to National Geographic - where "continuous presence" is sufficient, but the "slightest presence" is not - there is great room for factual variation, inconsistency, and confusion.
South Carolina has established nexus with a remote vendor through the in-state presence of intangible property.14 Similarly, New York interprets Quill as requiring only "demonstrably more than a “slightest presence'" and has found that as few as 12 sales-related visits by personnel of a remote vendor over 3 years is sufficient to establish nexus.15 However, other states have extended the common carrier exclusion of Quill and refused to find nexus where the remote vendor has only an attenuated presence in the state. In Tennessee, for instance, the presence of a credit-card issuer's direct-mail flyers and plastic credit cards are not together sufficient to establish nexus.16
Similarly, this principle can be extended to a vendor's transient presence in a state. In Department of Revenue v. Share International, Inc.,17 for instance, the Florida Supreme Court did not find nexus with a remote vendor whose sole employee was present in-state for only 3 days a year at a sales conference. In Kansas, eleven visits, averaging four hours each, by a remote vendor's technicians to assist customers in installing equipment, was held not sufficient to establish nexus.18 However, when a vendor's presence in a state is longer in time and greater in collateral activities, courts are more likely to find a physical presence. In Cole Bros. Circus, Inc. v. Huddleston,19 for example, a circus operator was in-state for only 29 days over two and one-half years, but extensively used the state's highways, advertised on the radio and newspapers, and applied for a business license. These factors, together, were sufficient for the Tennessee court to find nexus.
Generally, then, Internet-based remote vendors that deliver their tangible products via common carrier are exempt from sales and use tax liability and collection obligations.20 Furthermore, it is unlikely that general nexus principles can be extended to reach the download of intangible property, such as software, over the Internet, in what is essentially the exchange of electrical charges over copper wiring,21 though that will not preclude taxing jurisdictions from trying nonetheless. But as can be seen, there is no definitive national rule for establishing nexus, and resort must be made to each jurisdiction's statutory, regulatory and case law. As a general note, however, states have become more creative in trying to reach Internet-based remote vendors by attributing the physical presence of offline business partners to their online partners.
"Bricks-and-Clicks" Relationships
Though online vendors have great communications, marketing, processing, and some distribution efficiencies, many have begun to
establish strategic marketing and distribution relationships with offline vendors. These so-called "bricks-and-clicks" relationships try to leverage the efficiencies of the
online partner (the "clicks") with the established business capabilities of the offline partner (the "bricks"). The emerging problem for remote vendors is that the
"bricks" portion of the relationship may be great enough to expose the remote vendor to claims of nexus with all the states in which its offline partner operates.22 If nexus is successfully established by a taxing jurisdiction with the remote vendor, then the vendor loses its competitive advantage with offline sellers, is tax-disadvantaged in relation to its competitors that have remained online and do not have nexus, and may have to undertake vast new compliance functions.23
In an important but limited step, California,24 Texas,25 and New York26 have each established that a web page's presence on a server of an ISP located in the state is not sufficient to establish nexus with the state. However, the larger emerging issue is the ability of the states to establish nexus with remote vendors on the basis of attributional nexus - that is, imputing the physical in-state presence of offline partners to its remote vendor partner. Two primary theories of attributional nexus - alter ego and agency - are used by taxing jurisdictions. Case law specific to e-commerce is scarce, but the general case law developed to address an earlier age's marketing innovation - catalog merchandising to supplement retail outlets - is directly analogous and instructive.
Finding Nexus in Alter Ego Theory
Alter ego theory is generally used by courts to attribute the formally separate activities of individuals and businesses that derive commercial
benefits from the other's activities. In the context of a bricks-and-clicks relationship, general alter ego case law could have application where the offline partner uses its outside
sales representatives to market products sold by an Internet-based remote vendor. In Reader's Digest Assoc. v. Mahin,27 for instance, the remote vendor did not have employees or property in the state, but its wholly owned subsidiary sold the remote vendor's merchandise door-to-door and also sold advertising in its magazine on a contract basis. The parent-vendor also engaged in extensive in-state advertising on radio and television, and in local newspapers. In view of the extensive nature of these sales and marketing activities and the fact that all lines of the remote vendor's business benefited from them, the court attributed the in-state presence of the subsidiary's sales force to the remote vendor. Therefore, establishing the remote vendor's physical presence in the state. Although the case arose in the context of a parent-subsidiary relationship, the court focused instead on the extensive nature of the partnered marketing activities. That principle should be applicable to non-parent-subsidiary bricks-and-clicks relationships.
Co-marketing activities are typically less extensive when the Internet-based remote vendor and the offline business are not part of the same affiliated corporate group. But less extensive
marketing activities may also support application of alter ego theory. In Pearle Health Services, Inc. v. Taylor,28 for instance, the physical presence of franchisees in a state were attributed to a remote vendor which regularly sent representatives to the franchisees, not to solicit orders but to ensure product quality and to display the vendor's new products. The court held that the sales activities provided a basis for the vendor's exploitation of the state's consumer market. Accordingly, the principle may have application where a remote vendor seeks to use the outside sales staff of an offline business partner.
Finding Nexus in Agency and Corporate Affiliation
Separation of a businesses unit into formally separate entities has been generally respected. Bloomingdale's By Mail, Ltd. v.
Commonwealth,29 illustrates the point. In this case, neither the catalog unit nor the retail unit solicited or accepted orders for the other, though in two instances the retail unit's stores accepted return merchandise from customers of the catalog unit. All other catalog orders were delivered by common carrier. Though the units were jointly owned, the court respected their formal separation as they conducted their operations separately.
Though formal separation of units may be respected, courts regularly attribute the activities of sales representatives to their employers, however the employment relationship is structured
or characterized. In Scripto, Inc. v. Carson,30 the Supreme Court held that there is no constitutional significance between an employee and an independent contractor for purposes of establishing the physical presence of a vendor. Lower courts have generally extended this principle to encompass more innovatively structured marketing relationships.31 For instance, in Scholastic Book Clubs, Inc. v. State Board of Equalization,32 a remote vendor of books without physical property in the state sent its catalogs to teachers who solicited orders from their students and collected payment. The teachers also received shipment of books from the taxpayer and distributed them to their students. In exchange for these services from teachers, the taxpayer established a "premiums" program that allowed teachers to build up points that could be exchanged for personal or professional merchandise. Though they were not employees of the vendor, the court attributed the activities of the teachers to the vendors, finding that they essentially acted as distribution agents of the vendor.
One worrisome development in this area would be attribution of third-party warranty work to a remote vendor that contracts with the third party, as the Multistate Tax Commission has
advised.33 California, however, has explicitly rejected this position where the remote vendor and the third party performing the repair work do not have substantially similar ownership. Also of particular importance to remote vendors, Illinois has established that the presence of a sales manager in-state is sufficient to establish nexus with his remote vendor employer.34 If this position was widely adopted, it would threaten to expose remote vendors to nexus in every instance where an employee telecommutes from a separate jurisdiction.
Conclusion
As Internet-based vendors begin to rapidly expand, entering into new sales, marketing, supplier, and distribution relationships with businesses nationwide, often no or
small consideration is given to the impact those relationships will have on the ability of the vendor to avoid sales and use tax collection obligations, or liability for those taxes, in
thousands of taxing jurisdictions. There are, however, several practical steps that a remote vendor, or a local vendor that seeks to sell its goods over the Internet to other states, can
take to ensure minimum disruption of their business and financial operations from a later adverse ruling that sales and use tax collection obligations were applicable but not discharged:
- Gather Information.
At a minimum, someone within the vendor should have responsibility for systematically collecting the relevant information, including identifying all of the jurisdictions - state and local - in which the vendor sells products, identifying all of the vendor's offline and online suppliers, distributors, strategic partners, and agents, as well as the physical locations and operations of each.
- Legal Analysis.
Counsel should analyze the state of the law in all, or at least the major, taxing jurisdictions within which his or her client operates. This analysis should center on these questions: How aggressive is the jurisdiction in establishing nexus with remote vendors? Does the jurisdiction impose collection obligations on vendors or rely on self-assessment by individual consumers? How likely are the vendor's customers to self-assess and report? If the vendor fails to collect and remit sales and use tax, what are the applicable penalties and interest charges? How likely is an audit? Does the jurisdiction allow the vendor to go back and collect sales and use tax from customers if it is later determined that the vendor should have done so in the first instance? How will an adverse determination by one or several jurisdictions affect the client's financing or future merger prospects? Should these issues be disclosed during due diligence in a major corporate transaction?
- Competitive Analysis.
As part of its overall strategic planning, a remote vendor should factor in the issues of sales and use tax collection and liability into its competitive analysis. Among the questions that should be asked are: How central is exemption from sales and use tax to the success of the business? Does it make more sense to have closer ties to offline ("bricks") partners than to avoid a closer relationship because of tax concerns? If sales and use tax exemption are central concerns of the business, is there a way to restructure its operations - and its bricks-and-clicks relationships - to avoid establishing nexus with all or most jurisdictions outside of the vendor's home jurisdiction? If a vendor has nexus in a state, does it make sense to pull out of the state entirely and not do business there? Also, is it feasible to pull out of a state where the vendor has physical presence and then re-enter the state solely through electronic means?35
There are at least two major ironies in this field of law. The Supreme Court's failure to establish a single, uniform standard for establishing nexus may actually foster the economic
Balkanization that the Court's jurisprudence on the Dormant Commerce Clause has long sought to thwart.36 As thousands of taxing jurisdictions establish radically different nexus standards
and collection rules, and remote vendors may recoil from interstate commerce as a result. But just as technology, primarily the Internet, added new confusion to this area of the law,
there are emerging technology-based alternatives that may help remote vendors, in time, address some of their bewildering array of compliance obligations.37 Until then, however, the world
of "clicks" must struggle through the slow, paper-bound sales and use tax world of "bricks."
Footnotes
1. Pub. L. No. 105-277 (H.R. 4328), 122 Stat. 2681 (originally enacted Oct. 21, 1998); H.R. 1552, 107th Cong. (2001) (renewal). See also Associated Press, Internet Tax Ban Extended, Washington Post, November 16, 2001, at E02; Associated Press, Congress Extends Internet Tax Ban, New York Times, November 16, 2001.
2. David Hardesty, E-Commerce Tax Commission Issues One-sided Final Report, reprinted in eCommerce: Strategies for Success in the Digital Economy (Practicing Law Institute Intellectual Property Course Handbook Series No. G-618, New York, N.Y.), September, 2000, at 185.
3. Some states explicitly sanction passing through the tax to a vendor's customers. See, e.g., California Civil Code ¤1656.1.
4. See Associated Press, Internet Tax Ban Extended, Washington Post, November 16, 2001, at E02
5. ITFA, supra note 1, at tit. XI, 1101(a)(1).
6. Id. at tit. XI, 1101(a)(2).
7. Id. at tit. XI, 1101(e)(3)(D).
8. Id. at tit. XI, 1104(2)(A)(i), (ii); (2)(B)(ii)(I), (II).
9.
Congress has recently considered legislation that would codify the nexus standards. E.g., in 2001, the U.S. Senate considered S. 512 (Dorgan et al.) and S. 664 (Gregg and Kohl), and the House considered H.R. 1410 (Istook). Next year, the Senate will consider S. 288 (Wyden and Leahy) and the House will consider H.R. 2526 (Goodlatte et al.). In essence, these nexus bills: (a) codify the physical presence test, (b) create a single nexus standard for all business entity taxes (e.g., business and occupational taxes as well as sales and use taxes), (c) focus on specific activities within taxing jurisdictions, and (d) deem that some activities do not create nexus (e.g., visiting a vendor, soliciting sales of services that will be performed outside the state, or attending meetings). The proposed nexus legislation before Congress does not, in every instance, codify the current case law regarding nexus. For instance, some bill's drafters do not use the word "substantial" to describe the degree of physical presence required to create nexus. Harley Duncan, Presentation, Federal and State Tax Topics Before Congress (Twenty-Second Annual Conference of the National Association of State Bar Tax Sections, Oct. 2001). Some bills that were introduced before Congress in 2001, although involving the Internet Tax Freedom Act or sales tax simplification, also contained provisions that: (a) required states to enter Interstate Sales and Use Tax Compacts regarding internet sales and collections, (b) authorized twenty states to collect sales and use taxes on one another's behalf, and (c) permitted states with a simplified tax system to require remote sellers to collect taxes. See, e.g., S. 512 (Dorgan et al.), S. 1542 (Enzi), and S. 1567 (Enzi, Dorgan et al.).
10. U.S. Const. art. I, ¤8, cl. 3.
11. State taxation is also potentially subject to challenge under the Equal Protection Clause, U.S. Const. amend. XIV, ¤1, and the Privileges & Immunities Clause. U.S. Const.
amend. XIV, ¤1. Most litigation, however, results from the Due Process Clause, U.S. Const. amend. XIV, ¤1, and the Dormant Commerce Clause. U.S. Const. art. I, ¤8, cl. 3. The applicable
rule under the Dormant Commerce Clause in this area (i.e., physical presence of a remote vendor to establish nexus in a taxing jurisdiction) is more substantially more restrictive on
states than the more flexible "purposeful direction" standard of the Due Process Clause. Although analysis under the two clauses is formally separate, as a practical matter, due
process analysis is subsumed in Dormant Commerce Clause analysis. It is difficult to imagine any circumstances where nexus is successfully established under the Dormant Commerce Clause
but fails under the Due Process Clause.
12. 504 U.S. 298 (1992) (reaffirming National Bellas Hess, Inc. v. Dept. of Rev. of Illinois, 386 U.S. 753 (1967)).
13. 430 U.S. 551 (1977).
14. Geoffrey, Inc. v. South Carolina Tax Comm., 437 S.E.2d 13 (S.C. 1993) (finding the presence of accounts receivables and a royalty agreement sufficient to base taxing
jurisdiction).
15. Orvis Co., Inc. v. Tax Appeals Tribunal, 612 N.Y.S.2d 503 (App. Div. 3d Dept. 1994) (12 visits by remote vendors personnel over 3 years sufficient for nexus); Vermont Information Processing, Inc. v. Tax Appeals Tribunal, 615 N.Y.S.2d 99 (App. Div. 3d Dept. 1994) (40 visits over 3 years sufficient).
16. J.C. Penny Natl. Bank v. Johnson, 19 S.W.3d. 831 (Tenn. 1999).
17. 676 So.2d 1372 (1996).
18. In re Appeal of Intercard, Inc., 14 P.3d 1111 (Kan. 2000).
19. No. 01-A-01-9301-CH00004, 1993 WL 190914 (Tenn. Ct. App. June 4, 1993).
20. One complication may arise form the activities of some states to require the carrier itself to either collect the tax from the seller or pay the tax itself on goods it delivers.
This is known commonly as "drop-shipment nexus." See, e.g., California Revenue and Taxation Code ¤6007. The constitutionality of this form of tax collection obligation is uncertain. The argument that it does not violate Quill is
that the obligation is imposed on a carrier that certainly has nexus with a state (in the form of distribution centers and personnel) and not on a remote vendor that may not have nexus.
21. See Goldberg v. Sweet, 488 U.S. 252, 262 (1989) ("We doubt that States through which the telephone call's electronic signals merely pass have a sufficient nexus to tax that call").
22. This may be so even where not all of the activities of the offline ("bricks") partner are employed in its relationship with its online ("clicks") partner. In National Geographic Society, supra note 16 at 560, the Supreme Court rejected the argument that a specific activity of a remote vendor in a state had to have nexus with a state. The Court held that it was enough that the vendor itself had nexus. In other words, it may not be possible, in the context of a bricks-and-clicks relationship, to segregate those activities of an offline partner that a remote vendor wants to associate with from those that it does not. As such, all the activities of an offline partner should be analyzed in determining whether the bricks-and-clicks relationship risks exposing the remote vendor to nexus in a jurisdiction.
23. This combination of factors is so powerful that Amazon.com, a leading online seller of books, music, video recordings and other products, has filed suit against Barnes &
Noble, a leading offline seller of similar merchandise, in an effort to have the retail outlets of Barnes & Noble attributed to its online unit, BN.com. If the lawsuit is successful,
BN.com would lose is effective exemption from sales and use tax collection in all the states in which Barnes & Noble operates retail units. But there is a good business argument that
the loss of that effective exemption would be more than offset by more closely integrating Barnes & Noble's offline and online businesses. See Diane Brady, Commentary: How Barnes & Noble Misread the Web,
BusinessWeek, February 7, 2000 This reminds Internet-based remote vendors that sales and use tax considerations should not be the exclusive consideration in structuring their business
operations. Arkansas is in the forefront of states actively trying to reverse case law respecting the formal separation of offline and online units and to tax the online unit of an
affiliated corporate group as if the online unit physically operated in the state. See Arkansas H.B. 1440 (effective January 1, 2002).
24. Title 18 California Code of Regulations ¤1684(a).
25. Texas Comptroller of Public Accounts, Letter Ruling No. 9802118L (February 10, 1998).
26. New York State Department of Taxation and Finance, Memorandum TSB-M-97(1)C ((January 24, 1997); TSB-M-97(1)9S (January 24, 1997).
27. 255 N.E.2d 458 (Ill. 1970).
28. 799 S.W.2d 655 (Tenn. 1990).
29. 567 A.2d 773 (Pa. Commw. Ct. 1989). See also SFA Folio Collections, Inc. v. Bannon, 585 A.2d 666 (Conn. 1991)
30. 362 U.S. 207 (1960).
31. See Commissioner of Revenue v. Jafra Cosmetics, Inc., 742 NE2d 54 (Mass. 2001) (remote vendor's in-state sales force, with no power to bind company, is sufficient to establish nexus); Maryland
Comptroller of the Treasury v. Furnitureland South, Inc., (Maryland Circuit Court, C-97-37872, August 13, 1999) (remote vendor's use of delivery company that collected payment, made
repairs to goods, and returned damaged goods is sufficient for nexus); New York Department of Taxation and Finance, TSB-A-01(8)S, February 27, 2001 (remote vendor's use of manufacturing
representative in-state sufficient to establish nexus).
32. 207 Cal.3d 734 (Cal. Ct. App. 1989).
33. Bulletin 95-1 (December 20, 1995).
34. Illinois Department of Revenue, Letter Ruling No. ST 01-0052-GIL (March 2, 2001).
35. In some instances, this may actually be feasible. See Florida Department of Revenue, Technical Assistance Advisement No. 00A-020 (April 25, 2000) (holding that a vendor that
terminated its physical presence, but which then solicited in-state orders through a web site, did not have nexus).
36. See Hughes v. Oklahoma, 441 U.S. 322 (1979).
37. For instance, esalestax.com has developed an Internet-based software product that allows vendors to calculate their sales and use tax obligations and remit taxes to the
appropriate agency. What it does not and cannot do is determine whether a remote vendor has nexus in the first instance, thereby giving rise to sales and use tax collection obligations.
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